Germany Under Merz: Fiscal Reset, Defense Buildout, Industrial Triage

The Merz coalition and the 2025 fiscal turn #

The February 2025 federal election produced a CDU/CSU plurality of 28.5 percent, AfD at 20.8 percent, SPD reduced to 16.4 percent, the Greens at 11.6 percent, and Die Linke back in the Bundestag at 8.8 percent. The arithmetic ruled out any coalition including AfD, pushing Merz into a grand coalition with SPD sworn in on 6 May 2025. The coalition agreement traded Union priorities on migration and approvals reform for SPD priorities on a higher minimum wage path and the Sondervermoegen architecture.

The fiscal centerpiece moved before the new government was sworn in. In March 2025, the outgoing 20th Bundestag passed two constitutional amendments with the required two thirds majority: a 500 billion euro special purpose fund for infrastructure and climate transition over 12 years, and a carve out from the Schuldenbremse under Article 109 GG for federal defense, civil protection, intelligence, and certain cyber expenditure above 1 percent of GDP. The Federal Constitutional Court rejected an opposition challenge in late March.

Sondervermoegen Infrastruktur: scale, allocation, drawdown #

The 500 billion euro envelope is the second special fund of this scale in three years. The 100 billion euro Sondervermoegen Bundeswehr created in 2022 is largely committed by end 2026, with the residual absorbed into the new defense budget line that now sits outside the debt brake. The infrastructure fund is on book at the federal level, scored as debt for Maastricht purposes, and disbursed through line ministries against plans agreed with the Finanzministerium under Lars Klingbeil.

Transport infrastructure takes the largest single share, reflecting the 80 billion euro maintenance backlog at Deutsche Bahn and an Autobahn renewal pipeline the Rechnungshof flagged as severely behind schedule. Energy and grid investment, education, and digital infrastructure follow. Execution is the binding constraint: the Bundesrechnungshof report of February 2026 noted only 9 percent of the fund's first tranche allocations had cleared planning approval by year end 2025, and the November 2025 Genehmigungsbeschleunigungsgesetz is still being implemented at Land level.

Defense: the 3.5 plus 1.5 path and the industrial base #

At the June 2025 Hague summit, NATO endorsed a new core defense spending floor of 3.5 percent of GDP plus 1.5 percent on defense related infrastructure and resilience, to be reached by 2035 with a review point in 2029. Germany committed to a faster path. The 2026 federal budget books core defense at 2.4 percent of GDP, rising to 3.0 percent by 2028 and 3.5 percent by 2032, with the additional 1.5 percent envelope funded partly through the infrastructure Sondervermoegen and partly through Laender contributions to civil protection. Because everything above 1 percent is exempt from the Schuldenbremse under the March 2025 amendment, the marginal euro is debt financed rather than crowding out civilian spending.

The industrial absorption question is unresolved. Rheinmetall, Hensoldt, KNDS Deutschland, Diehl Defence, and MBDA Deutschland have lifted order books to record levels, but lead times on artillery ammunition, air defense effectors, and tracked vehicles remain 30 to 48 months. The Generalinspekteur's 2025 readiness report found fewer than 60 percent of major Heer platforms fully mission capable. The move from one off catch up to a sustained 3.5 percent baseline requires structural expansion of domestic production, skilled labor, and supplier qualification that the primes say will take through 2028 to deliver.

Industrial relief: power prices, Heizungsgesetz, EU ETS2 #

Industrial Germany entered 2026 with the most expensive electricity in the G7. Destatis reported industrial power prices, including taxes and levies, averaging 19.4 cents per kWh in Q4 2025, against 8.1 cents in France and 7.7 cents in the United States Gulf Coast. The Merz coalition's Strompreisbremse for energy intensive industries, in effect from 1 January 2026, caps the wholesale component at 6 cents per kWh for qualifying users in chemicals, steel, glass, paper, and ceramics, with the gap funded from the Climate and Transformation Fund. The EEG umlage was set to zero in 2022 and remains so under the new framework, with renewables remuneration paid directly from the federal budget.

The Gebaeudeenergiegesetz, the heating law that defined the late Habeck era, was substantially softened in autumn 2025. The 65 percent renewable heating mandate for new boilers remains, but the deadline for retrofits in existing buildings was pushed from 2028 to 2032, and the municipal heat planning trigger was loosened. The reform reduces near term household compliance costs and political risk around the AfD's heating cost campaign, at the price of a slower decarbonization trajectory in the buildings sector that the Umweltbundesamt projects will overshoot the 2030 sector budget under the Klimaschutzgesetz.

EU ETS2 launches in 2027 and will price carbon in road transport and buildings fuels across the EU. The Bundesfinanzministerium estimates a pass through to German households of 12 to 19 cents per liter on heating oil and diesel at a 55 euro per tonne ETS2 price, against the soft cap of 45 euro before the Market Stability Reserve releases additional allowances. The coalition's Klimageld, a per capita rebate funded from ETS2 receipts, is scheduled to start in Q1 2027, but the disbursement infrastructure through the Bundeszentralamt fuer Steuern is not yet operational and the political risk if the rebate slips behind the price increase is substantial.

Auto and chemicals restructuring #

Volkswagen entered 2025 in open conflict with IG Metall over the first plant closures in its German history. The December 2024 Tarifeinigung avoided shutdowns at Wolfsburg, Osnabrueck, and Dresden but committed to a reduction of around 35,000 German jobs by 2030. Mercedes Benz announced in February 2026 a 5 billion euro cost program targeting 4 billion euro of run rate savings by 2027, including consolidation of powertrain capacity at Untertuerkheim. BMW has held up better thanks to a more conservative China exposure profile, but its 2026 guidance assumes flat unit volumes and compressed margins.

The proximate cause is Chinese competition. Chinese brands took 13.4 percent of the European EV market in 2025 (ACEA), up from 7.9 percent in 2023, and BYD, NIO, and Xpeng now produce in Hungary and Turkey to circumvent EU countervailing duties. Volkswagen's China joint ventures, historically a third of group profit, fell to a single digit contribution in 2025. The OEMs are responding through software and platform partnerships: VW with Rivian, Mercedes with Geely, BMW through the Debrecen cell plant.

BASF's restructuring is parallel. The company confirmed in late 2024 the permanent closure of a steam cracker, an ammonia plant, and a TDI line at Ludwigshafen, and is shifting incremental capital toward the Zhanjiang Verbund site and Antwerp, now repositioned as the European battery materials hub. The signal for German chemicals is unambiguous: marginal capital is leaving, and the question is whether the Strompreisbremse and hydrogen core network arrive in time to retain inframarginal capacity.

Demographics, the Rentenkommission, and labor supply #

Germany's working age population peaks in 2025 and declines through the late 2030s (Destatis 14th coordinated projection). The Rentenkommission's 2025 final report recommended a phased increase in the retirement age beyond the existing 67 by 2031 trajectory, a demographic factor in the pension formula, and expansion of the Aktienrente capital stock from 12 billion euro to 200 billion euro by 2035. The coalition agreement adopted the capital stock element and shelved the retirement age extension under SPD pressure, creating a financing gap the Bundesbank estimated at roughly 0.6 percentage points of GDP per year by 2035.

The Skilled Immigration Act, in force from 2024, lifted non EU work permit issuance, with 87,000 Chancenkarte applicants approved in 2025. Yet net migration of around 350,000 in 2025 falls short of the 400,000 to 500,000 the IAB estimates is needed to stabilize the labor force. The Buergergeld reform tightens activation requirements, projected by the BMAS to lift labor supply by 80,000 to 120,000 full time equivalents by 2028.

European coordination and the security perimeter #

The French German Treaty refresh in early 2026, building on the Aachen framework, formalizes a joint defense industrial procurement track, a coordinated position on EU electricity market reform, and a common line on China industrial overcapacity. The substance is thinner than the choreography, particularly on nuclear, but coordination on EU Commission von der Leyen II priorities is operational: the Clean Industrial Deal, the Competitiveness Compass, and the Defense Industrial Strategy rely on Franco German alignment to clear Council votes.

The security perimeter is tightening. The BND and the new Bundeswehr Cyber and Information Domain Service have absorbed dual use export control responsibilities under the 2025 Aussenwirtschaftsgesetz amendment, with screening obligations on advanced semiconductor manufacturing equipment, AI compute exports, and quantum technologies. The BfV upgraded its classification of the AfD core party in 2025 from suspected to confirmed right wing extremism, a designation that has triggered internal CDU debate about the firewall and exposes CDU politicians at Land level to coalition arithmetic problems in eastern states ahead of 2027 elections. This shapes the political space within which fiscal and industrial decisions are made.

Sources #

• Bundeshaushalt 2026 and supplementary 2025 budget documentation
• Monthly Report November 2025: Public Finances and the Special Funds
• Volkswirtschaftliche Gesamtrechnungen and Industrial Energy Prices, Q4 2025
• Germany 2025 Article IV Staff Report
• Clean Industrial Deal and Competitiveness Compass implementation tracker
• Generalinspekteur Annual Readiness Report 2025
• Kieler Konjunkturberichte: Deutsche Wirtschaft im Fruehjahr 2026
• ifo Konjunkturprognose Fruehjahr 2026
• IW Trends: Investitionsstandort Deutschland 2026
• Germany approves landmark spending plan in historic shift
• BASF accelerates Ludwigshafen rationalisation as Antwerp pivots to batteries